The End Is Near, Part 5: Paying Dividends With Borrowed Money
A recent Goldman Sachs report explains where this year's stock market profits (should there be any) will come from:
Dividends and buybacks will be responsible for supporting a market where the median stock in the Standard & Poor's 500 Index is trading at 18.2 times earnings, putting it in the 99th percentile of historical valuation, the firm said in a note to clients. Goldman Sachs forecasts that the S&P 500 will rise to 2,150 by mid-year before fading to 2,100 by the end of 2015.
S&P 500 stock values "have limited scope for further upward expansion," a group of Goldman Sachs analysts including Kostin, the firm's chief U.S. equity strategist, wrote in a May 15 client note. "Dividend yield will be the sole contributor to total return during the next 12 months," they said.
This would be fine (or at least not outrageous) if corporate cash flows supplied the necessary cash. But they don't:
The increased borrowing is a sign that companies and individuals are feeling more confident about taking risks as a strengthening economy makes the debt more manageable, according to experts who say that the level of indebtedness isn't yet a cause of concern the way that it was before the financial crisis.
Net leverage for highly rated U.S. nonfinancial companies, a measure that tracks debt less cash as a multiple of annual earnings, was 1.88 times at the end of 2014, according to Morgan Stanley data. That is up from 1.63 times at the end of 2007, on the eve of the financial crisis.
U.S. corporate-debt issuance so far this year has jumped to $609 billion, from $568 billion in the same period last year, according to recent figures from Dealogic.
Junk-rated firms, with ratings double-B-plus or below, are borrowing at an elevated pace, sometimes a warning sign for analysts who track market cycles. But defaults remain low and few analysts expect to see a sharp rise in defaults until the economy falls into recession, something that isn't widely expected in the coming year.
The trailing 12-month default rate for junk-rated U.S. companies was 1.9% at the end of March, Moody's Investors Service said, compared with nearly 15% during the financial crisis.
Aggregates, of course, contain a lot of variation. Some companies are maintaining rock-solid balance sheets while some others are borrowing amounts that used to be characteristic of entire countries:
The company said it would use the proceeds for general corporate purposes, including share buybacks and acquisitions. At its annual shareholders' meeting in March, Qualcomm committed to buying back $10 billion in stock over the next 12 months. At the time, the company said it would use available cash and debt to do it.
A majority of Qualcomm's cash is overseas and can't be used to buy back shares without tax consequences. So the company is taking on debt instead.
At the peak of each bubble, market participants start doing extreme things in order to keep the party going. And each time analysts rationalize the debauchery by citing differences between their bubble and its predecessors. Today's rationalizations include the usual suspects of fat corporate profit margins, low interest rates and ultra-low default rates on risky loans.
These didn't save the previous bubble and won't save the current one. All bubbles eventually burst, and when they do their dominant rationalizations are revealed to be mere wishful thinking. Corporate profits plunge, interest rates spike, junk bonds default en mass. And the valuations those things supported evaporate.
But this time around there actually is one big difference: Governments are actively buying stocks and bonds, apparently without regard for price or implied future returns. So when (not if) the current bubble rationalizations blow up, there may be one final buyer to keep the party going for a little while longer. At taxpayers' expense.